Economic models are simplified descriptions of reality. Models can be used to yield insights into economic behaviour. These insights, in turn, can be used to develop hypotheses about future behaviours that can be tested. So, the power of models lie in their ability to generate insights and develop predictions about what may happen in the future.
Simple models – toy models, as I call them – can yield surprisingly powerful insights about economic behaviour. For example, even the simple line model developed by Harold Hotelling can yield surprisingly useful insights about firm behaviour under product differentiation.
How do we build models? Hal Varian, Google’s chief economist has written extensively on this (Paul Krugman is another), and we tend to follow the principles espoused by those two eminent thinkers. As Varian says, the first step is to identify the various pieces of the model. For example, in most models there are economic agents who interact in some way. These economic agents could be firms, consumers, etc. These agents have to make choice decisions in order to achieve their desired objectives. The choices of the economic agents are usually bounded or constrained within the model – for example, buyers may face budget constraints, firms may face capacity constraints, etc. The presence of constraints suggests that there must be something in a model that adjusts to ensure that the choices made by economic agents are mutually consistent.
When modeling, we always strive for simplicity or, more properly, to simplify complexity. It is a complex world out there, and a model should always strive to reduce complexity to something that is tractable. For example, simple one or two-period models, with two agents, two goods, and linear utility can often yield surprisingly powerful insights into consumer behaviour. Relaxing the assumptions on which the model may be built – for example, homogenous goods, constant prices, etc. – allows the modeler to more closely approximate reality, yielding further insights.
Economic models are powerful tools with which to try and make sense of complex market interactions and behaviours. Besides yielding useful insights, they often yield results that can challenge well-held assumptions and beliefs. As such, economic models are an integral part of our strategy and marketing practice at ALCG.